What You Know About the VIX Is Wrong - Here's How to Trade It

Shah Gilani

Most people who know anything about the stock market probably know a few things about the VIX (INDEXCBOE: VIX). (I was one of the traders on the floor of the Chicago Board Options Exchange who came up with the VIX, so I probably know a bit more than most!)

Investors know "the VIX" is a volatility index and that it is often called "the fear index." They know that when the VIX is rising especially quickly, there's a chance there's going to be trouble ahead and markets might be in danger of selling off... or possibly crashing.

But that's like looking at the tip of an iceberg and saying that's all you need to know about what's underneath the surface. That would be a huge mistake. Just ask the captain of the Titanic.

I'm sharing, without the heavy math, a clear look-through to the depths of the VIX as opposed to what you think you see on the surface.

Here's what you need to know about what really floats the VIX and how to trade it for huge gains...

The Whole Truth About the VIX

First of all, the VIX is a measure of the volatility of the S&P 500 (INDEXCBOE: SPX).

However, the VIX is not the only volatility index (or "vix"). There are volatility measures or indexes based on other stock market benchmarks, like the Dow Jones Industrial Average (INDEXCBOE: VXD) and the Nasdaq 100 (INDEXCBOE: VXN).

There's a vix for the 10-year U.S. Treasury (INDEXCBOE: TYVIX), Crude Oil (INDEXCBOE: OVX), and Gold (INDEXCBOE: GVX). There's even a vix of individual stocks like Amazon (INDEXCBOE: VXAZN) and Apple (INDEXCBOE: VXAPL). My programming team has developed proprietary vix measures of almost every stock, as well as other instruments. Goldman Sachs has all its vix measures, as does every quant shop.

There's even a VIX Volatility Index (INDEXCBOE: VVIX).

According to the CBOE:

Every asset class deserves its own volatility index, including volatility itself. The VVIX Index is an indicator of the expected volatility of the 30-day forward price of the VIX. This volatility drives nearby VIX option prices. CBOE also calculates a term structure of VVIX for different VIX expirations. The VVIX or any point on its term structure is calculated from a portfolio of VIX options (VVIX portfolio) using the same algorithm used to calculate the VIX. Approximate fair values of VIX futures prices and their standard deviations are derived from the VVIX term structure. Selling a VVIX portfolio on a consistent basis can capture a volatility risk premium.

I know I said I wouldn't get into heavy math; just pat yourself on the back that you know there's a vix of the VIX.

What most investors don't know, however, is that the VIX (or any vix for that matter) isn't exactly what it's supposed to be. It's close, but it just isn't.

The VIX is calculated from a series of puts and calls on the SPX expiring within 16 to 44 days, and the number derived from that calculation is the market's expectation that the S&P 500 (the SPX) could go up or down.

For example, say it's 10.65 (about where it closed yesterday). That would indicate the markets expect the SPX to go up or down 10.65% in the next 12 months. If the number derived from the calculation was 40 (which is very high), that would indicate the markets expect the SPX to go up or down 40% in the next 12 months.

When investors see the VIX rising to 40, there's panic that the market's pending move over the next 12 months won't be up 40%, but down 40%. Hence the nickname "the fear index."

But what's wrong with that understanding is that's not exactly what's going to happen.

This is what I mean when I say the VIX isn't exactly what it's supposed to be. You'd see the VIX at 40 and think, "Trouble ahead, big trouble!" However, what people are using it to predict (or what it's "supposed to be") has already happened.

The VIX can only get to 40 if there's a lot of buying of puts, and probably a lot of selling of calls. But mathematically there's more weight (skew) on the puts component of the VIX than the calls. Investors are buying puts and paying up for them to hedge portfolios and to profit from a downdraft or big sell-off.

Newsflash! If the VIX is at 40, it's already happened; the markets already dropped enough to warrant bidding up premiums (prices) for puts as fear and selling set in.

What I'm saying is that by the time investors see the VIX at 40 and interpret that to mean that in the coming 12 months the SPX could move up or down 40%, it's already mostly happened.

That should be a revelation. And it should give you a distinct leg up when trading the VIX.

How to Trade the VIX Better Than Anyone Else

Shah Gilani

About the Author

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Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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